Two Good Candidates, But Only One Portfolio

The bottom-up style of stock selection — that is, beginning the selection process by analyzing individual equities as opposed to starting with studies of industries and sectors, then singling out companies — poses a problem for investors who focus on fundamentals. When looking at sales and earnings growth, profitability, return on equity and the stock’s valuation, they need to put these figures in context.

Earning
20 percent on each dollar of sales might seem like a healthy profit, for
example. But if the company’s competitors are earning 30 percent, they might
wonder whether the company is doing as well as it should. Fundamental analysis
of individual stocks should therefore include consideration of how a company is
performing relative to its peers.

In
this article we’ll compare the fundamentals of two companies, CVS Caremark
(ticker: CVS) and Walgreen Company (WAG), and try to decide which one provides
the better opportunity for investment. I chose CVS and Walgreens because
they’re well-known (particularly among BetterInvesting’s membership) and offer
a relatively easy comparison.

This
isn’t always the case. Various financial information services detail a
company’s competitors, but in my experience the peers selected often don’t
reflect the true competitive landscape. They’re often chosen because they’ve
been slotted into a specific industry classification without further analysis
of the company’s market. Investors should check the company’s annual reports,
or even call the investor relations department, for a truer picture of peers.

An Orderly Process

Before
beginning a comparison, it might save time to see whether both companies are
even worth studying. What we look for at BetterInvesting are sales and earnings
growth rates that are above average for the company’s size; consistent growth
of sales and earnings; and growing or stable profitability and return on
equity. If a company passes these tests, we have some assurance that we’re
looking at a well-managed company worth considering for investment. In this
case, we’ll say that despite struggling along with everybody else in recent
times, both CVS and Walgreens are worth our time to study.

Our
comparison begins by checking the sales and earnings growth rates for both
retail pharmacy companies. Before CVS acquired Caremark in 2007, CVS and WAG
had similar sales growth rates. This makes a lot of sense; after all, when one
company opens a store, the other often builds one across the street. The
Caremark acquisition significantly boosted sales for CVS, however, and sales at
CVS grew at almost 14 percent in over the past two years, compared with 8.5
percent at Walgreens. The graphs also indicate that Walgreens’ growth lines
seem to be flattening.

As
for future growth, both companies seem to have similar prospects overall. CVS
and Walgreens face challenges in their industry, but sales and earnings growth
of 9 percent-10 percent over the next five years seems plausible. (Note that
analysts, who are typically optimistic in their forecasts, are expecting
long-term earnings growth of 12 percent for CVS and 14 percent for Walgreens as
of early July.)

Our
two tests of management effectiveness — pretax profitability and ROE — provide
differing results. CVS and Walgreens had quite similar profitability over the
past five years, with WAG coming out slightly ahead and generally being more
consistent over a 10-year span. CVS has had the upper hand over the past two
years, however. Meanwhile, Walgreens has had better ROE over the past 10 years.
CVS has seen its ROE profile change since the Caremark acquisition, with ROE
dropping to below 10 percent in 2007-2009.

We
also note that CVS has carried more debt relative to capital over the long
term, with percentages exceeding 25 percent since 2006. Walgreens generally has
had debt to under 10 percent over the past 10 years. But we aren’t too
concerned about the debt load at CVS; it’s a healthy, well-run company with a
strong balance sheet.

Studying Valuation

So
far, so good. Although CVS has the upper hand regarding growth, given the
recent economy and industry headwinds, both companies remain interesting
candidates.

Now
it’s time to study valuation. The BetterInvesting methodology favors growth
companies, but not growth at any cost. A stock’s current price-earnings ratio
and expectations of future P/Es are important elements when forecasting return
potential.

Over
the past five years, CVS has had an average high P/E of 20.4, compared with
25.3 for Walgreens. Unsurprisingly, these P/Es have also been trending
downward. In 2009, the high P/Es were 14.9 for CVS and 17.2 for Walgreens. The
low P/Es tell a similar story. And the current P/Es (based on the most recent
four quarters’ EPS) are pretty close: 11.5 for CVS versus 13.1 for Walgreens.

It
might not be prudent to expect Walgreens to trade at a high P/E of 25 in future
years. In fact, we could reasonably expect P/Es to remain at lower levels over the
next five years, especially if inflation takes hold. For the sake of this
exercise, let’s forecast a high P/E of 17. The multiple of CVS would likely
follow a similar fate, with a high P/E of 15 seeming reasonable. On the low
side, let’s project a P/E of 9 for CVS and 10 for Walgreens.

Now
we’re ready to begin considering the return potential. When we multiply the
high P/E by the expected high EPS (which we determined by starting with the
most recent EPS and compounding the predicted growth rate over the next five
years, we come up with the high price. On the low side, a common option for
growth companies is to multiply the expected low P/E by the expected low EPS
(which, for a growth company, should be the most recent EPS).

We
then have a spread between the low and high potential price and an idea of the
risk versus the return. We like to see at least $3 of potential gain for every
dollar of potential loss. We also hope the stock’s potential return is at least
15 percent annually.

In
this case, based on our projections both stocks pass these tests. Our forecasts
lead to what’s called the upside-downside ratio of 4.6 to 1 for Walgreens and
5.1 to 1 for CVS. The potential annual return is 16.7 percent annually for CVS
and 16.9 percent for Walgreens. (Both companies pay a dividend, by the way,
with the yield for Walgreens being higher than that for CVS.)

Decision Time

So
which stock is the better investment? Based on our judgments, both seem to have
similar prospects. They’re both very well-managed and have shown an ability to
sustain growth and survive difficult times.

This
is often the situation when you’re studying industry leaders. My preference in
these cases is to focus on the potential growth and P/Es of the companies. The
long-term EPS growth rate projections are similar (analysts expect a little
higher rate for Walgreens). So we turn to the P/Es and see that CVS is trading
at a lower P/E and is projected to have an average high P/E that’s lower than
Walgreens.

Your
judgments and final call might well be different. But unless my additional
study of the companies — the stock studies I’ve detailed provide about 80
percent of what I need to know — tell me otherwise, CVS comes out a winner in
this comparison by a nose.